J.P. Koning, a CoinDesk columnist, worked as an equity researcher at a Canadian brokerage firm and is a financial writer at a large Canadian bank. He runs the popular Moneyness blog.
Bitcoin is often described as digital gold. If bitcoin is to be the next version of the yellow metal, then 2020's gold market may have plenty to teach us about what bitcoin will be like in 2030.
While each molecule of gold is physically the same, not all gold is economically the same. The gold market is effectively a two-tiered system. At the top of the hierarchy is gold housed in a carefully walled garden in London. Everything else that doesn't meet London's strict standards – the second-rate gold – is held outside of the City.
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Given how regulations are slowly shaping bitcoin, this same degree of standardization may be well on its way to emerging. The upper tier of bitcoins will be made up of all the clean, carefully Know-Your-Customer'ed (KYC) stuff housed at approved exchanges and custodians. The second tier will be everyone else's sub-standard, or “dirty,” bitcoins.
I'm going to provide a rough sketch of the London gold market, then suggest how this applies to bitcoin. The London bullion market is the most energetic gold market in the world. No where else in the world is it possible to sell as much gold, as quickly, at such low fees.
But not just any gold qualifies for entry to the London market. The London Bullion Market Association (LBMA) – an elite group of banks, refiners and transport companies – presides over the London "good delivery" rules. This is a set of standards that, if closely followed, grants a gold bar entry into the London system.
To qualify as London good delivery gold, the gold must be in bar form, not coin or dust or jewelry. Not just any bar qualifies. Each bar has to meet the LBMA's specifications for size (250 x 70 x 30 mm), weight (400 ounces), and purity (at least 99.5% pure). The details and placement of the markings stamped on each bar are also prescribed by the LBMA. And only bars produced by refiners from the LBMA's accredited list are allowed into the system.
Good delivery gold can only be held in a handful of vaults located in and around London that are operated by LBMA members. There are currently 8,452 tons of London good delivery gold, worth around $464 billion. So 5% of all gold ever mined conforms to the LBMA's standards.
Movements of gold bars from one LBMA vault to another are recorded and tracked. This preserves the "chain of custody." Should a London good delivery bar be withdrawn from an LBMA-approved vault (say someone wants to hold it under a mattress), it immediately falls out of the custody chain and loses its elite good delivery status.
Once a bar falls out of the chain of custody, the only way to get it back into the London system is to bring it to an LBMA-approved refiner. It will be re-assayed for a fee before re-approval as good delivery gold. Bars produced by unapproved refiners can only make it into the London system if they are melted down and upgraded into an approved bar.
The net effect is that any bars held outside of London aren't worth as much as the ones inside – they lack the LBMA's imprimatur. If it can't be traded in London, it isn't as liquid. And so it's not as valuable.
So how does this all pertain to bitcoin? Many of the mechanisms for an informal bitcoin version of the LBMA are already present: a core group of regulated exchanges; the emergence of companies that specialize in analyzing bitcoin flows; and an emerging class of speculators who care about getting accredited bitcoins.
There are good reasons for building a carefully sterilized system. In the case of gold, the stuff can be easily faked. Bars with a core of tungsten and a gold shell are common. LBMA standards screen these bars out. Counterfeits, those bars made of genuine gold but falsely marked, are also warded away. So are poorly produced bars, say 98% pure. The combination of the LBMA's rules and the chain of custody guarantees that the world's biggest buyers, institutional investors such hedge funds, central banks, banks and exchange traded funds, are getting only the best gold.
Bitcoin suffers from neither a purity problem nor a counterfeiting problem. The network of independent bitcoin validators ensures that every bitcoin is indeed a 100% real bitcoin.
But it does have its own unique quirk. The entire blockchain is public, so the flow of bitcoins can be tracked. And trackability means some bitcoin addresses may not be as good as others – they may hold funds that were stolen from an exchange, or used to pay ransom, or have been mixed by an anonymizer. These aren't the sorts of bitcoin addresses that a sophisticated investor wants to be associated with.
Gold, like bitcoin, can also be dirty. Drug cartels, for instance, are notorious for buying up gold mines in order to launder money. But the LBMA is working hard to cleanse the supply chain. An accredited refiner will only convert a customer's gold into an approved gold bar if that customer passes a due diligence process set out in the LBMA's Responsible Gold Guidance. So refiners are obligated to have the same KYC procedures as a bank.
The LBMA also requires refiners to screen out gold that has been used in human rights abuses or the financing of conflict. The LBMA market recently suffered through some uncertainty when The Perth Mint, a major refiner, was accused of refining gold sourced from a convicted killer in Papua New Guinea. In theory, this meant that The Perth Mint's gold bars could be kicked out of the London system. Which would mean they'd be worth less. But, after investigating, the LBMA announced that it was compliant. Gold bar owners breathed a sigh of relief.
And so, in theory, not only is a London gold bar 99.5% fine but it hasn't been sourced from drug dealers or crooks. So-called "blood gold" is left to trade in informal, less liquid markets, where it is worth less.
Bitcoin's version of the LBMA would be made up of 10 or so approved exchanges and a few large non-exchange custodians. Bitcoins held in this system would easily pass from exchange to exchange, or exchange to custodian, much like how London gold can move from LBMA vault to LBMA vault. But once they were to be withdrawn from the system, say to someone's personal address or to a non-accredited bitcoin exchange, the "chain of custody" would be broken.
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To get withdrawn bitcoins back into the walled "good bitcoin" garden, approved analyzers like Chainalysis or CipherTrace would have to check the transacional history for anything iffy, much like how today's LBMA-approved refiners carry out due diligence.
Anything that couldn't be verified would be denied access to the system. These non-accredited bitcoins would circulate in a gray economy where they are worth much less. To avoid any risk of losing premium status, it would become increasingly uncommon for bitcoin users to withdraw bitcoins from any of the approved exchanges.
Bitcoin purists would no doubt bristle at the encroachment of this centralized Bitcoin LBMA; not your keys, not your bitcoin. But the Bitcoin LBMA would attract most bitcoin liquidity. Institutional investors, say Grayscale or Paul Tudor Jones, will always prefer to buy bitcoins that are part of an approved chain of custody, just like they’ll always prefer to buy the LBMA’s good delivery gold.
If bitcoin is going to become digital gold, it’s quite possible a bitcoin version of the LBMA will develop. So far a hierarchy hasn't arrived. Or has it?